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The Hedging Corner: Hedging Rules – Part I

Manufacturing requires a plan. You don't go about it haphazardly. Similarly, hedging is most effective and beneficial with a management-approved plan in place (i.e. Rules) before any hedges are executed. Once the Rules and a qualified person or team is tasked with implementation, hedging is fairly routine and the risk of uncontrolled costs, weak margins, conflicting strategies, second-guessing, and beginner-hedger mistakes is minimized.

Further, the stronger the risk management team and the clearer the Rules, the more competitive and profitable the manufacturer is because hedging supports the manufacturer's objectives. It does not conflict with them. Hedging enables manufacturers to spend less time worrying about costs, profit margins, customer good will, and such, and instead spend more time on product development and improvement.

Hedging rules should specify what to hedge, how far forward to hedge, approved hedging tools and strategies, authorizations, when hedges may be closed, reporting requirements, etc. The Rules should be clear and concise, and approved by upper management. They should also be relatively easy to establish since they reflect a manufacturer's risk tolerance and strategies.

The Rules are rules, not guidelines. They must be followed and should only be changed as agreed and approved by the same managers who first approved them. Typically, establishing the Rules is a one-time exercise. It results in effective and efficient hedging, so it is well worth the time and effort.

Getting to the Rules

Perhaps you've already taken some of the steps below and are ready and able to move forward with establishing hedging rules (step 6) and implementing them (step 7). However, all these steps should be formally addressed before any hedging takes place.

1)    Identify and prioritize your top five (or fewer) business objectives. For example, secure margins, customer and geographic diversification, revenue growth, customer loyalty, cost control, etc.

2)    Identify market risks that could hinder or prevent achieving your top objectives.

3)    Define your risk tolerance. What market risks do you want to control and to what extent do you want to control them? (E.g., limit or eliminate the price risk on 50% of your resins purchases on a rolling six-month basis; lock in a profit margin when it exceeds a required minimum; etc.)

4)    Discuss and answer the tough questions (more on this to come in The Hedging Corner).

5)    Identify and prioritize ways to limit or eliminate risk (e.g. financial tools to manage resins prices).

6)    Establish clear and concise hedging rules (a.k.a. a risk management policy): procedures, roles and authorities, approved tools and strategies, hedge accounts and funding, reporting requirements, etc. Obtain management approval.

7)    Implement the risk management policy -- this is where hedging is done.

Depending on the risks to be managed and the extent they will be managed, a risk management policy may be just a few pages. A good risk management policy is clear, concise, and an asset. Look on it as a friend! It makes hedging easier and most effective (i.e. smart), which makes manufacturing more secure and profitable.

(Ed. Note: In case you missed it, here a link to the last in The Hedging Corner series, entitled "It's all about margin - Part II.")

About the author: Tom Langan is a risk management and trading consultant who operates WTL Trading. He specializes in commodity cost control, loves to trade options, and enjoys teaching others ways to protect and increase the value of their manufacturing and personal portfolios. He has worked with private and public entities, as well as individuals, in helping control and take advantage of volatile oil and gas, electricity, resins, and metals prices.  More background information here.

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